How Inequality Works

By Angus DeatonProfessor of Economics and International Affairs at Princeton University’s Woodrow Wilson School of Public and International Affairs

Ukrainian feminists and their supporters hold posters and placards during their rally in downtown Kiev, Ukraine, 08 March 2017, as Ukrainians celebrate the International Women's Day. They want to remind of the political and human rights of women worldwide and demand a full equality of both sexes. International Women's Day started as a Socialist political event and is celebrated annually on 08 March. Slogans on the banners reading like 'It's enough to cover up inequality by traditions!', 08 March is the day of fighting for the rights!', 'Just rights will stop the lawlessness!' and so on.

Inequality has been named as a culprit in the populist incursions of 2016 and 2017. But what is inequality, and what role does it play in inhibiting or encouraging growth, or in undermining democracy? Does inequality kill, say, by driving people to suicide or to “deaths of despair”? Or is inequality a necessary evil that we must tolerate at certain levels?

These are questions I am often asked. But, truth be told, none of them is particularly helpful, answerable, or even well posed. Inequality is not so much a cause of economic, political, and social processes as a consequence. Some of these processes are good, some are bad, and some are very bad indeed. Only by sorting the good from the bad (and the very bad) can we understand inequality and what to do about it.

Moreover, inequality is not the same thing as unfairness; and, to my mind, it is the latter that has incited so much political turmoil in the rich world today. Some of the processes that generate inequality are widely seen as fair. But others are deeply and obviously unfair, and have become a legitimate source of anger and disaffection.

In the case of the former, it is hard to object to innovators getting rich by introducing products or services that benefit all mankind. Some of the greatest inequalities today are a consequence of industrial and health revolutions that began around 1750. Originally, these processes benefited just a few countries in northwest Europe. But they have since improved living conditions and health outcomes for billions of people around the world. The inequalities stemming from these advances – both within and between countries – are beneficial and fair, and a key feature of progress generally.

On the other hand, getting rich by bribing the state for special favors is clearly unfair, and rightly resented. Many in the United States – more so than in Europe – automatically regard capitalist or market outcomes as fair, and government action as arbitrary and unfair. They object to government or university-sponsored programs that seem to favor particular groups, such as minorities or immigrants.

This helps to explain why many white working-class Americans have turned against the Democratic Party, which they view as the party of minorities, immigrants, and educated elites. But another reason for growing public discontent is that median real (inflation-adjusted) wages in the US have stagnated over the past 50 years.

There are two different explanations for the divergence between median and top incomes, and it matters a great deal which one is correct. The first attributes it to impersonal and unstoppable processes such as globalization and technological innovation, which have devalued low-skill labor and favored the well educated.

The second explanation is more sinister. It holds that median-income stagnation is actually the direct result of rising incomes and wealth at the top. In this account, the rich are getting richer at the expense of everyone else.

Recent research suggests that there is some truth to the second story, at least in the US. Although globalization and technological change have disrupted traditional work arrangements, both processes have the potential to benefit everyone.

The fact that they have not suggests that the wealthy have captured the benefits for themselves. It will take much more work to determine which policies and processes are holding down middle- and working-class wages, and by how much, but what follows is a preliminary list.

First, health-care financing is having a disastrous effect on wages. Because most Americans’ health insurance is provided by their employers, workers’ wages are essentially paying for profits and high salaries in the medical industry. Every year, the US wastes a trillion dollars – about $8,000 per family – more than other rich countries on excessive health-care costs, and has worse health outcomes than nearly all of them. Any one of several European financing alternatives could recoup those funds, but adopting any of them would trigger the fierce resistance of those now profiting from the status quo.

A related problem is increasing market consolidation in many sectors of the economy. As a result of hospital mergers, for example, hospital prices have risen rapidly, but hospital wages have not, despite a decades-long shortage of nurses. Increasing market concentration is probably a factor underpinning slow productivity growth, too. After all, it is easier to reap profits through rent-seeking and monopolization than through innovation and investment.

Another problem is that the US federal minimum wage – currently at $7.25 per hour – has not increased since July 2009. Despite broad public support, raising the minimum wage is always difficult, owing to the disproportionate influence that wealthy firms and donors have in Congress.

Making matters worse, more than 20% of workers are now bound by non-compete clauses, which reduce workers’ bargaining power – and thus their wages.

Similarly, 28 US states have now enacted so-called “right-to-work” laws, which forbid collective-bargaining arrangements that would require workers either to join unions or pay union dues. As a result, disputes between businesses and consumers or workers are increasingly settled out of court through arbitration – a process that is overwhelmingly favorable to businesses.

Yet another problem is outsourcing, not just abroad, but also within the US, where businesses are increasingly replacing salaried or full-time workers with independent contractors. The food servers, janitors, and maintenance workers who used to be a part of successful companies are now working for entities with names like AAA-Service Corporation. These companies operate in a highly competitive low-wage industry, and provide few or no benefits and little opportunity for advancement.

The earned income tax credit (EITC) has provided a boost in living standards for many low-paid US workers. But, because it is available only to those who work, it puts downward pressure on wages in a way that unconditional benefits, such as a basic-income grant, would not.

Unskilled immigration also poses a problem for wages, though this is controversial. It is often said that immigrants take jobs that Americans do not want. But such statements are meaningless without some reference to wages. It hard to believe that low-skilled Americans’ wages would have remained as low as they did in the absence of inflows of unskilled immigrants. As the economist Dani Rodrik pointed out 20 years ago, globalization makes demand for labor more elastic. So, even if globalization does not reduce wages directly, it makes it harder for workers to get a pay raise.

Another structural problem is that the stock market rewards not just innovation but also redistribution from labor to capital. This is reflected in the share of profits relative to GDP, which has grown from 20% to 25% over the same period that median wages have stagnated. The increase would be even higher if executive salaries were counted as profits rather than wages.

The final problem on our preliminary list is political. We have entered a period of regulatory bonfires. The Consumer Financial Protection Bureau, despite having uncovered major scandals, is now under threat, as is the 2010 Dodd-Frank legislation, which introduced measures to prevent another financial crisis. Moreover, President Donald Trump has indicated that he wants to eliminate a rule requiring money managers to act in their clients’ best interest. All of the deregulatory “reforms” currently being proposed will benefit capital at the expense of workers and consumers.

The same is true of US Supreme Court rulings in recent years. The court’s decision in Citizens United v. FEC, for example, gave wealthy Americans and even corporations the ability to spend almost unlimited amounts to support candidates and engineer legislative and regulatory outcomes that work in their favor.

If this account of stagnant median wages and rising top wages is correct, then there may be a silver lining to our era of inequality, because it means that the US’s dysfunctional labor market is not an irremediable consequence of unstoppable processes such as globalization and technological change.

Broadly shared progress can be achieved with policies that are designed specifically to benefit consumers and workers. And such policies need not even include redistributive taxation, which many workers oppose. Rather, they can focus on ways to encourage competition and discourage rent-seeking. With the right policies, capitalist democracy can work better for everyone, not just for the wealthy. We do not need to abolish capitalism or selectively nationalize the means of production. But we do need to put the power of competition back in the service of the middle and working classes.

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